Why the Holidays Aren’t Merry for UPS and FedEx

You might expect that the holiday quarter would be the best period of the year for UPS (NYSE: UPS) and FedEx (NYSE: FDX) -- but the two shipping giants consistently lose a pretty big chunk of margin during the busy period.

In this week's episode of Industry Focus: Energy, analysts Sarah Priestley and Adam-Levine Weinberg dig into why that is. Find out why the holidays are a logistical nightmare for these companies, and how they're working to fix that; how much of a threat Amazon's (NASDAQ: AMZN) proposed delivery service is to the incumbents; why retailers across the board are running into trouble with shipping costs; which company is the better buy today; and more.

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A full transcript follows the video.

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This video was recorded on Dec. 7, 2017.

Sarah Priestley: Welcome to Industry Focus, the show that dives into a different sector of the stock market every day. Today, we're talking energy and industrials. It's Thursday, Dec. 7, and we're going to be discussing UPS and FedEx. Joining me on Skype is senior Motley Fool contributor Adam Levine-Weinberg. Adam, thank you so much for joining me today!

Adam Levine-Weinberg: Thanks for having me on your show!

Priestley: As I said, today, we're going to be talking about UPS and FedEx. We thought, as we are well into the holiday season, it would be seasonally appropriate to talk about two companies that make a lot of our online shopping and gift-giving possible. The number of packages that get sent during this season is just phenomenal. Between Thanksgiving and Christmas, UPS, FedEx, and United States Postal Service expect 2 billion packages. They expect to deliver 2 billion. Not only is that insane, but it's also 70% higher than it was in 2010. So, that's a lot of gifts, a lot of socks that are getting delivered. So, between the two companies we're talking about, they're obviously pivotal to all this activity.

If you as a listener are not familiar with them, FedEx is the world's largest express delivery firm. They pioneered overnight delivery in the 1970s, and are known for their huge air fleet, among other things. Its ticker symbol is FDX. United Parcel Service, unsurprisingly, their ticker is UPS. They are the largest player. They deliver, on average, 19 million packages every day across the globe, and they handle about 40% more volume than FedEx. Adam, management of both of these companies are probably super laser focused on the holiday season right now, which hasn't always been kind to them. What do you reckon they're prepping for?

Levine-Weinberg: One of the issues that both FedEx and UPS have had over the years is that they need to invest a huge amount of money in order to handle that increased shipping volume that they see over the holidays. FedEx has said that they expect on three particular days, three Mondays during this holiday season, that they're going to see more than double their daily average package volume. So, it's not easy when you have a company that's built to deliver a certain number of packages every day, and all of the sudden, for one month of the year, or even a part of one month, to start delivering twice as many packages. So that's the general problem that they have. Both FedEx and UPS need to add additional capacity.

So, that can involve opening extra sorting centers, finding short-term rentals on extra vehicles, even extra aircraft, getting more people, either paying overtime to their existing staff or hiring temporary staff over the holidays. All of those things drive up costs because when there's a run on a particular item, such as delivery trucks, that's obviously going to have an impact on your cost structure. So this is what both FedEx and UPS are struggling with. If we think about how they've been doing in the past over the holiday season, what you've typically seen is, the profit margins for FedEx Ground, that's the ground delivery portion for FedEx, and for UPS, their domestic operations, it's often not as high as you would expect during the holiday seasons. This has particularly been an issue for FedEx, where 2% to 3% is a pretty average drop in their operating margin over the holiday season compared to the rest of the year. And that actually may be understating the extent of the problem, because those are full quarterly results, and the holiday shopping season is only really one month out of that quarter. So, this is definitely something that both companies have said they're working on, but so far, they haven't mastered the art of getting capacity in at a reasonable cost for that peak shipping season.

Priestley: That's something that we see a lot of companies struggle to deal with, but this is such a particularly big peak and trough, having that elasticity and capacity is very difficult. I think UPS is hiring, I may get this wrong, but I think it's 95,000 people this season. Just to actually go through the process to hire that amount of extra bodies is incredibly expensive and challenging, I'm sure. Are they going to do anything to try to combat these problems this holiday season and try and recoup some of that expenditure?

Levine-Weinberg: Yeah. Both companies are definitely trying to solve this problem. One thing that they're both doing is investing a lot of money in technology. They want to try to be as efficient as possible, make it as easy as possible to scale up and scale down the amount of deliveries that they're doing over the holiday season. One example of this is, UPS has a technology that they've been working on for at least five years called ORION, which is basically an automated tool that tells drivers how to do their routes. It's basically using a huge amount of data about traffic, about when particular people are going to be home to accept their deliveries, and it tries to create the most efficient routing essentially, so that drivers can deliver more packages in a particular day.

If you look at both FedEx and also UPS, they have come up with tools that allow them to move volume between their Post Office products and their regular ground delivery products. Both of these companies have partnerships with the Post Office, where they can offer retailers and other shippers a cheaper option. For FedEx, it's called SmartPost. For UPS, it's called SurePost. The idea is, FedEx or UPS handles the big job of getting the package to the ZIP code where it needs to go, but then they hand it off to the Post Office, and then the postal carrier does the final delivery, which is the most expensive part of that process. The idea behind that is, the Post Office, because of all the mail they carry, they're going to every address every day, so it's not as out of the way for them to do an extra delivery of a package. But, what this technology does is, it allows FedEx and UPS to cut out that middleman at the Post Office, if they know they're already going to be going to that address or the next-door address that same day. So, if I have a package coming through regular UPS that's going to be delivered in two days, and somebody else sends something by the SurePost method, UPS can tell that they're already going to be at my address, and instead of handing that second package off to the Post Office, they can deliver both and save time and save money.

So, that's how they're trying to cut costs. But they also need to raise revenue. That's been the more controversial part of their plan. For UPS in particular, they're going to be implementing peak-season shipping surcharges, which started this year, and they've already announced that they're going to be slightly raising the price of these surcharges next year. During the two weeks leading up to and immediately after Thanksgiving weekend, there's a $0.27 surcharge on UPS Ground packages. That surcharge then goes away for two weeks and comes back in the week before Christmas. For the air packages, there are even higher surcharges. It's $0.81 on the next-day air, and it goes up to $0.97 for the two-day and three-day packages. Those surcharges are only in that last week before Christmas, so that's from Dec. 17 up until Dec. 23. The idea behind these surcharges is to try to give retailers an incentive to shape demand. Not offer so many promotions with free shipping right around Black Friday or right in the last week before Christmas, and instead try to get their customers to spread out their orders over this whole one-month period, because that will basically allow UPS to deliver the same number of packages spread out in a way that they won't need as many resources to do it. So, they're trying to make the very biggest shipping days a little smaller, and the less busy days during the season a little busier to average out. So far, UPS is happy with how it's working. I think they are seeing some shift in the shipping patterns in response to this new pricing strategy.

Priestley: Yeah. I saw their CEO talking about the difference between a want and a need. A lot of these deliveries are, they would like to have them. And I think they've been very smart in terms of analyzing the data. A lot of Black Friday purchases that are electronics, etc., are generally gifts for Christmas that can be delayed in their delivery. And, I think, as he said, a lot of people are picking up these delayed delivery options when it's a lower price impact, it's just how price-sensitive people are to these things. I think UPS announced a general rate rise for next year of 4.9%. Is that effective on everything? Or is that just particular to the surcharges?

Levine-Weinberg: That's a general increase. They're increasing the surcharges on top of the 4.9% increase.

Priestley: I think, to some degree, this kind of suggests an element of pricing power that they have, given that there's an oligopoly in this industry. Do you think that FedEx is going to benefit at all from these price increases?

Levine-Weinberg: FedEx thought about it and ultimately decided to not have a peak surcharge. One thing that they are doing, which UPS is also doing, is implementing a bigger surcharge on oversized items. Generally, the constraint in terms of what fits in a truck is space rather than weight. So, really bulky items just aren't worth it for them to be carrying during this holiday season when their trucks are totally full. So, they're trying to encourage people to not be sending these things, and if they need to, they're going to charge them more. So that's one way that FedEx is responding. But for the most part, they're just hoping to gain market share by saying, "We're customer friendly, we're not going to charge you extra just because you need to ship around Black Friday or the week before Christmas." Of course, the problem is, that could leave them in the same place they were last year or the year before, where they are incurring huge extra costs during this December and late November period, and don't actually bring in enough revenue to justify those costs. So, we'll just have to see how it works out for FedEx.

Priestley: I think they've been eroding margins for quite some time now. Their contribution from the consumer segment margins fell from 18% in 2012 to 13% last year, which is a sizable shrinking, something that we're not always used to seeing. Do you think this will have an impact for retailers and shoppers like you and me?

Levine-Weinberg: We are seeing some retailers start to change their policies in response to UPS implementing this holiday season surcharge. Macy's (NYSE: M), for instance, which exclusively uses UPS for their shipping, decided that they're going to start offering a little bit of an incentive to people who are willing to take a slower shipping speed. You'll get some Macy's Money, which you can then use later on during the holiday season or thereafter in the store. So, it's a way to both drive more traffic later on, but also convince people to take the slower shipping speed, which is going to be cheaper for Macy's, because they can wait until a week later to ship it out, and then ship it when there's no surcharge effect. That's particularly something that works around Black Friday, Cyber Monday. Obviously, that doesn't work for people who are looking to buy a gift in the last week before Christmas. Those people just need it right away. And at that point, Macy's is just going to have to pay the surcharges. This no-rush shipping is not new to the retail industry. Amazon has been offering it for many years. Depending on what you're ordering, you'll get an offer, $5 off music, $10 off a Prime Now delivery, $10 off Amazon Restaurants -- it's always some kind of offer if you're a Prime member and you're willing to take a seven- to 10-day delivery instead of the two day that you're entitled to. What's going to be interesting here is just how many consumers take the retailers up on these offers, just because, once Amazon has gotten people used to having this free two-day shipping, so now every retailer feels like they need to offer a free and fast shipping option, and too much just expect that as standard. So even if they don't need something right away, it's not clear to me how many people will take that slower option. It's going to really depend on how well retailers target their offers to convince people to actually take them up on the slower shipping speed.

Priestley: That will definitely be interesting, and it would change the landscape quite a lot if they managed it with this whole carrot method like you were talking about, offering something in return for slower shipping. If that really works, it could really help a lot of these retailers to stop eroding margins by offering so much, because delivery is just crazy expensive. Actually, Marc Lore, who's with Wal-Mart now, he was talking about that on the company's most recent earnings call. If anybody has the time to go check that out, it's really interesting what he's saying, talking about the implied costs of actually picking the product and shipping it, and what that adds vs. in store, it's really incredible.

Based on your knowledge of these two stocks now, Adam, which would you feel a little bit more confident about today?

Levine-Weinberg: I would say that I'm not a huge fan of either one right now.

Priestley: Oh, wow.

Levine-Weinberg: But, I would say that UPS sounds like the better choice because FedEx has two issues right now. First, they have a really big integration process with this acquisition that they made a couple of years ago of TNT Express, a big Dutch package delivery company. There's big upside, but also a lot of risk in trying to get those two parts of the Express business combined. The second issue with FedEx is that they have been spending huge amounts on capex. And part of that is trying to revamp their aircraft fleet for their Express business, but another part of that is building up capacity for FedEx Ground, because they are trying to deal with this big situation just by adding more and more sorting centers and trucks every year. UPS has been a little more disciplined on capital spending, so they've had much better free cash flow. That's why they are a slightly better option. But as a caveat, I would say that UPS is also starting to increase their capex significantly, so that could cut into free cash flow there as well.

Priestley: Absolutely. Some people like UPS for their dividend, too. There are really only two players in this field. My last question for you is possibly a bit of a curve ball, but I feel like we can't get away without mentioning it. Both stocks dropped in October when it was announced that Amazon was launching somewhat of its own fleet. How much of a risk do you feel like this is to these stocks?

Levine-Weinberg: If Amazon is just delivering its own packages, it's not much of a risk at all. Amazon being such a large shipper, it's going to carry very low margins. As we've talked about, carrying these e-commerce deliveries is not very profitable, both because of the high cost of residential deliveries, the space it takes up in the trucks, there's just a lot of downsides to it. If Amazon starts to really go into the business as a business and selling delivery services to other companies, that would be a little bit more of a headwind. But FedEx and UPS have a pretty big moat in terms of the sorting centers they have, the fleets they have. That's not to say that Amazon couldn't enter the business. They've shown over the years that they're willing to spend billions, even tens of billions of dollars, once Jeff Bezos has decided that he wants to get into a new business. But I think FedEx and UPS really do have a pretty big moat nonetheless.

Priestley: Yeah, I think you're completely right. Amazon, as you said, constitutes a mid-single digit proportion for UPS and low-single digit proportion for FedEx also. I think it's very hard to get into this market, and I think people underestimate that. If you remember, DHL exited the U.S. market, understandably, in 2009 after they were losing money hand over fist. Obviously, that was a different economic environment, but it just shows you that this was an established company that invested a ton of money, and they still couldn't make it work. It's just a very hard business to get into.

Levine-Weinberg: Yes.

Priestley: Well, thank you very much, Adam, for joining me on the show! Hopefully we'll have your back sometime soon.

Levine-Weinberg: That sounds great!

Priestley: That's it from us today. If you would like to get in touch, please feel free to email us at industryfocus@fool.com or tweet us on Twitter @MFIndustryFocus. As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. For Adam, I'm Sarah Priestley. Thank you for listening and Fool on!

John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Adam Levine-Weinberg owns shares of Macy's. Sarah Priestley has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Amazon. The Motley Fool recommends FedEx. The Motley Fool has a disclosure policy.